There are so many different answers to the above question that it may be better to first address the question, "What is an annuity?" To find that answer, we turned to multiple industry insiders. All agreed that an annuity should provide the annuitant, or client, with a stream of income. In essence, annuities are, by their nature, distribution vehicles. As such, the use of any annuity should have at its core a distribution strategy. Without this, all annuities will eventually become tax time bombs.
Unfortunately, this leaves us with another question: Why do so many annuities never get annuitized? Although I have not been able to get an exact percentage, I have been told by several industry insiders that about 85 percent of all annuities and well over 90 percent of non-qualified annuities are never paid out. This may indicate that consumers are purchasing annuities without ever giving thought to the distribution mode. So this brings us to back to the original question -- "Why use an annuity?" First, you need to understand the different types of annuities and their suitability.
Single premium immediate annuities (SPIAs)
Here, we find the very essence of annuities. In exchange for a single, lump-sum premium amount, SPIAs provide a guaranteed income for a specified period of time or for the client's lifetime. In the case of non-qualified money, they also have the advantage of offering a tax-exclusion ratio.
Besides their obvious use as income vehicles, SPIAs can be beneficial in many situations. For example, they can be used to fund premiums for life insurance or long term care insurance.
Fixed deferred annuities: Single premium (SPDAs) and flexible premium (FPDAs) Deferred annuities are classified as distribution vehicles, where the distribution schedule is set at some point in the future. Meanwhile, the funds can accumulate in a tax-deferred contract with a guaranteed interest rate as declared by the issuing insurance company. Their primary use is as savings vehicles that compete directly with certificates of deposit.
Why use a deferred annuity rather than a CD? Because according to Invest and California Federal Savings Bank, 89 percent of all CDs are purchased for periods of one year or less, while 54 percent of all CD money has been in there for more than five years. Hence, many people are using short-term, highly taxable, low-rate vehicles (CDs) for their long-term savings. Rather than fighting the FDIC battle, use those statistics during your sales call and follow it up by asking the prospect if they think that information makes sense. Then, present the tax advantages of using a fixed deferred annuity.
Index annuities (IAs)
There are many misconceptions about IAs, but love them or hate them, they are here to stay. Those who take the time to study and understand them will find that they are extremely powerful.
Similar in format and use to fixed deferred annuities, index annuities take a more aggressive stance on the accumulation phase than fixed annuities do. Instead of 100 percent of the funds being placed in a guaranteed account, the index annuity offers options to place all or a portion of the funds into an indexing strategy. The index strategy methods vary, but the bottom line is that they give the client the opportunity to participate in market gains, usually the S&P index, without the risk of market loss. But here's the catch: The client is not investing in the market, and these annuities are not and should not ever be presented as being securities.
Usually, these gains are limited to a capped rate set by the insurance company. Still, the annuitant has the opportunity to create greater gains that are locked in every year. Since the gains are locked in every year, the pattern of growth only goes up or takes a side-step if the S&P is negative.
Variable annuities (VAs)
Variable annuities are also tax-deferred annuity/distribution vehicles, but unlike fixed products, these annuities are in fact considered securities. A securities license is required to present or sell them, and suitability is a major consideration. The funds are invested in market sub-accounts and are therefore subject to market risk. There are many gives and takes that must be considered when looking at both the annuity's accumulation and distribution phases.
Long term care annuities (LTC-annuities)
A newcomer to the market, these annuities are designed specifically to address long term care. To a certain extent, they all work in the same way in that they all provide a higher distribution over a shorter period of time than regular annuities do. Generally, they pay the entire annuity value over two or three years based on a pre-determined formula.
What makes these LTC-annuities unique is that the client has the option to purchase additional coverage of two years, three years, or even a lifetime, and payments would continue even after the original annuity value is exhausted. Some offer inflation protection, and at least one company even offers the client the option to add a second person. It is even possible to use qualified money to fund these annuities.
So when should you use an annuity? It depends on the client's goals. Whether a single annuity or a blend of several, the tax benefits and risk transfer elements associated with these products make them a wise financial choice for many. But without question, all annuity presentations should have at their heart an exit strategy that the client understands and agrees with. After all, by their nature, annuities are ultimately distribution vehicles.
Jonathan Neal is the senior partner at CCG-Capital Consulting Group, an Atlanta-based sales and marketing consulting company. Wendy Weant, CSA, CLTCA is a CCG affiliate.
